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Equitable taxation: a precondition for meaningful economic reform

Negotiations with the IMF on the next programme are ongoing, with budget formation being an integral part of the discussions. The government is requesting a full allocation of $7.6 billion, while the IMF is offering $6 billion over 3.5 years. As the saying goes, “there is no free lunch,” and the government must meet tougher conditions to secure a larger allocation. IMF Managing Director Kristalina Georgieva has aptly stated, “More for more, less for less.” Reality demands acceptance.

To obtain the larger allocation, the government must agree to harsher conditions. One of these is increasing the top marginal rate of personal income tax to a staggering 45%. Other measures include taxing all incomes, such as rental income and capital market instruments (bonds and stocks), at standard personal income tax rates.

If the government does not accept these harsher terms, it may have to settle for a $6 billion loan. Regardless, the medium-term budget framework aims to increase the tax-to-GDP ratio by 3-4% by the end of the programme, preferably within the first two years. This is a tough challenge, no doubt.

The Federal Board of Revenue (FBR) is struggling to collect taxes from retailers and traders, while potential sectors for tax collection (like GST on services, municipal taxes, and agricultural income tax) are under provincial jurisdiction. Without these sectors being taxed, the burden shifts to those already in the tax net. Hence, the proposal for an extremely high-top tax rate of 45%. This could be a punitive tax. Honest taxpayers have already been tested over the past two years, where stagflation and higher tax rates have significantly affected the salaried class. The formal business sector is further squeezed by the imposition of a super tax. Meanwhile, non-paying sectors continue to evade taxes. What is unseen is not only hard to tax but likely to remain untaxed for that reason. This invisibility strategy helps the informal sector avoid the tax net, seeing what has happened to those already taxed.

How can the government consider imposing further and higher taxes on the formal, compliant sectors, including the salaried class, while admitting its inability to tax the ‘holy cows’? The government’s authority is at stake.

The purpose of taxation should be to tax the rentier class, grow the middle class, and protect those at the bottom, helping them rise to the middle class. Incentives to climb the economic ladder must be vigorously promoted. Taxing an already stagnant income group (middle/salaried class) is the worst possible taxation choice.

Someone earning Rs500k per month and paying high taxes should expect something in return from the state, as is the case in developed and developing economies. These states provide quality schooling, healthcare, and security, among other benefits. In Pakistan, the return for paying high taxes is negligible.

The misery worsens when the salaried class sees traders and retailers among their friends and family paying minimal direct taxes and enjoying better lifestyles. The marginal taxpayer tends to either join the informal sector, leave the country, or become disillusioned with the taxation system.

Short-term tax/revenue gains at the expense of suppressing middle-class consumption are far less beneficial than long-term gains from taxing untaxed sectors. The goal should not be merely to increase tax revenue but to broaden the tax base for a better taxation policy. Goodhart’s Law is relevant here: “when a measure becomes a target, it ceases to be a good measure.” If enhancing tax receipts becomes the sole measure, it will fall disproportionately on already taxed classes, regardless of the adverse consequences.

The issue of a shrinking formal sector is evident in products where tax rates are too high. A classic example is tobacco, where the effective indirect tax is around 80% of the retail price, leading to a booming informal market. Higher tax rates make illicit trade more profitable and justified, undermining national spirit.

Formal businesses are trying to expand their footprint in the grey sector as their effective direct taxes have risen due to the super tax. The salaried class may start demanding portions of their salary in cash, which is not possible in MNCs and formal businesses, leading many to leave the country.

Taxation should not increase the cost of production for the entire economy, making it unable to export its surplus for foreign exchange. The goal of taxation is to lower production costs for sectors that can either meet local demand, thereby growing the local economy, or enable export sectors to compete globally. Currently, the country has little competitive export surplus, with textiles being a notable but declining exception.

In summary, a suboptimal taxation policy will either drive the economy into informality or oblivion, while top talent continues to leave. This is a recipe for disaster. The government must pause, rethink its taxation strategy, bring rationality to the table, and start taxing the ‘holy cows.’ Without a country, there can be no politics.

Ali Khizar, "Equitable taxation: a precondition for meaningful economic reform," Business recorder. 2024-06-10.
Keywords: Economics , Taxation policy , Tax revenue , Salaried class , Budget formation , Income Tax , Loan , Taxes , Kristalina Georgieva , Pakistan , IMF , FBR

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